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The argument by talking point style that characterizes all sections of the political right in the US has been evident as usual in relation to the financial crisis, so I guess it’s time to play whack-a-mole yet again. The most prominent points I’ve seen are

* It’s all the fault of the Community Reinvestment Act, which forced banks to lend to low-income borrowers. Quite a few people have pointed out that many of the subprime loans weren’t required under CRA. More to the point, given that the market structures in the bubble made mortgages a fungible asset, the CRA was a nonbinding constraint. It’s clear that many more subprime loans were given out in the bubble years than were required under the Act and that the excess was greatest in the areas where the bubble was worst. The CRA had no effect at all under these conditions.

* If regulation were the problem, how come the hedge funds haven’t been affected? In fact, it was the failure of Bear Stearns hedge funds that signalled the spread of the crisis beyond the subprime mortgage market. And the main reason hedge funds haven’t yet been hit by the crisis of the past few weeks is that they don’t allow redemptions except at stated dates (for most of them it will be next Tuesday. Perhaps there won’t be a problem, but that’s not what the markets think. In any case, those making the claim seem to be unaware of the redemption restrictions.

I’ve been arguing since the dotcom boom and bust that the poor performance of (particularly US) financial markets provides strong evidence against the claim that neoliberalism provides a coherent and effective alternative to social democracy. One objection that’s been made to this argument is that “neoliberalism” is a poorly-defined pejorative. It’s true all political terms are elastic and it’s hard to find any that are used, with more or less the same meaning, by both friends and foes. The only one I can think of is “social-democratic”, though you could perhaps make a case for “liberal” in the US sense. Words like “conservative”, “democratic” and “socialist” have become just about meaningless.

By contrast, I think “neoliberalism” is a comparatively well-defined term. It’s mostly, though not exclusively used in a pejorative sense, so perhaps something like “free-market liberalism” would be better. This post from 2002 gives my definition and some reasons why I thought then that neoliberalism was a failure. I don’t see much reason to revise my assessment in the light of events between now and then.

Since the collapse of the US financial system became undeniable, I’ve been struck by the number of people insisting that this has no implications for free-market policies because the US (and particularly its financial sector) is not truly a free-market economy. [1]

In the spirit of market economics, I want to offer a trade to all such people. I will agree that
(a) the US is not a free-market economy, and its failures do not constitute evidence against the claim that a pure free-market economy is the best possible form of social organization
(b) no other actually existing society is, or has ever been, a free-market economy, and no actual or conceivable events anywhere constitute evidence against the claim that a pure free-market economy is the best possible form of social organization
(c) In discussion with parties to the agreement, I will not contest the claim that a pure free-market economy is the best possible form of social organization

All I ask in return is that the counterparties to the deal agree not to advocate, oppose, criticise, or comment on any policy or political position that might actually be implemented, to ensure that the purity of the free-market ideal is not compromised by actual experience.[2]

fn1. Since I haven’t checked, I’ll assume that this set of people has zero overlap with those I once debated who insisted that the supposedly superior performance of the US economy over social-democratic competitors demonstrated the superiority of free market economics.
fn2. I’m willing to make the same offer to Marxist-Leninists and (two for the price of one) to combine both offers for free-market Marxist-Leninists

My column in yesterday’s Fin started with the observation “The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed.”

Ignoring my own advice, I wrote a piece yesterday for Crikey (over the fold) which included the prediction “The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.” By the time it appeared today, it was a postdiction.Read more…

One thing that really puzzles me about the great bailout plan is the almost universal acceptance that Paulson should be the one to run it, at least until the next Administration. More generally, I’m surprised by the kid-glove treatment he’s been getting in public discussion, even from people highly critical of the plan.

Let’s stipulate that he’s a smart guy. He wouldn’t have risen to the top in Wall Street if he wasn’t. And, of course, if having smart guys running the show was sufficient to ensure good outcomes, Wall Street wouldn’t be in its current mess.

Looking back at the record, plenty of people have observed that, at least in his public statements, Paulson repeatedly underestimated the severity of the crisis. And there’s nothing in the ad hoc shifts between cash infusions, bailouts and bankruptcies to suggest that he has much more of an understanding of what’s going on than anyone else. As Paul Krugman has said, he’s making it up as he goes along, just like the rest of us.

But the bailout plan is something else. The possibility of a meltdown like this has been talked about, increasingly seriously, for the last couple of years. Yet Paulson responds with a three page document saying “I need $700 billion, no questions asked”. Wasn’t there a contingency plan? Or worse still, was this the contingency plan?

Steven Poole is taking a break from blogging, so we can’t get his thoughts on the “clean bailout” as an example of Unspeak. To me the natural association is something like “clean handover” as in “I want a clean handover. Leave the money in unmarked used bills, no tricks and no police, nobody gets hurt”

I’ve been finding it hard to concentrate on the future of the planet for the last week or so, what with the nationalisation of vast segments of the financial sector, the disappearance of all four remaining US investment banks, the trillion dollar bailout and so on. But I’m going to be presenting a lecture for UQ research week on Wednesday night, entitled “Climate Change and the Murray Darling Basin”. The news isn’t good but there is still some hope if we act swiftly and sensibly. Perhaps the other speaker will have something more solidly positive to tell us. He’s Professor Paul Burn Federation Fellow, School of Molecular & Microbial Sciences talking on ‘Can Light Solve the Energy Crisis?’

The way t’ fix it, uz I maintain, Is only jest T’ make that place uz strong uz the rest”.

On the Fed’s current approach, the system is unbreakable, provided that “too big to fail” protection is extended to every significant firm in the system. The result of this protection is that the kind of crisis where the failure of one firm leads to a cascade of failures elsewhere is prevented. But then

First a shiver, and then a thrill, Then something decidedly like a spill,– And the parson was sitting upon a rock, At half-past nine by the meet’n'-house clock,– Just the hour of the Earthquake shock!

–What do you think the parson found, When he got up and stared around? The poor old chaise in a heap or mound, As if it had been to the mill and ground! You see, of course, if you ‘re not a dunce, How it went to pieces all at once,– All at once, and nothing first,– Just as bubbles do when they burst.

By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

“At the end of 2002′s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.[1]

It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.

I don’t think even the most alarmist of doomsayers could have anticipated the pace of events in financial markets over the past couple of weeks. In that time, the casualties (bankrupt, nationalised or firesale) include Fannie and Freddie, Merrill Lynch and Lehman, AIG and HBOS and probably others I’ve missed. And the new names on the list are even more startling: Goldman Sachs, Morgan Stanley, Macquarie Bank, GE, even the Federal Deposit Insurance Corporation.

As late as last week, columnists were asking (and answering in the negative) the question “Should I take my money out of the stock market and put it in a money market fund”. Now the question is “If I pull out of the money market funds before they shut down redemptions, what’s the safest alternative: a bank account, T-notes or gold?”.

No doubt, this too will pass. But it’s just about impossible to see things returning to the status quo ante. A severe recession now seems inevitable. And when it ends, we’ll be looking at a greatly contracted financial sector, with governments deeply enmeshed in both ownership and regulation. Among the likely consequences, a huge decline in the economic importance of New York City, as the firms that defined Wall Street disappear. London may gain relative to New York, but is still likely to suffer badly, as will Switzerland. And that will have implications for the national economies that depend heavily on playing a central role in the financial systems.

Politically, even allowing for the incredible triviality of US election campaigns, it’s hard to see McCain surviving once the implications of this sink in. From the Keating Five to deregulation in the 90s, he’s been in the pockets of the financial sector throughout his career.

Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.

Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.

BTW, if you happen to have cash parked in a US money market fund, you might want to read this. (Insert disclaimer about financial advice)

Due to the pressures of real life, I haven’t reacted to the change in Liberal leadership with the lightning speed for which the blogosphere is famed. A couple of thoughts on the players and the implications.

For Nelson, this was only a matter of time. He’s a likeable guy (though of course, the job of Opposition leader typically requires some unappealing behavior) and was of fair average quality as a minister in the last government*, but he was not ready for the leadership of a major political party. Costello’s decision to reject the job (while continuing to collect a parliamentary salary for doing nothing except promote his future career plans and book sales) put him up too soon. As leader by default, he’s floundered from one contradiction to the next. On the whole, losing this job is probably a good thing for him, giving him a chance to start again.

As regards Turnbull, he’s obviously one of the more able people Australian politics has seen in my time. I must say, though, that I’ve marked down my estimate of him pretty sharply over the last couple of years. As Environment Minister, although he clearly understood the issues, he achieved nothing in his tenure of the job. In fact, water policy went a long way back thanks to Howard’s National Water Plan, introduced with Turnbull’s acquiescence. And, if he had the capacity to get things done that I expected of him, he would have made the Cabinet see the obvious sense in swallowing its pride and ratifying Kyoto.

As Shadow Treasurer, he’s been similarly unimpressive. He had a good run early while Swan struggled to come to grips with the job, and particularly its Parliamentary aspects. But he hasn’t made any attempt to mount a sustained critique of the government’s approach, let alone offer a constructive alternative. Rather he’s gone along with the generally opportunistic line taken by the Opposition as a whole.

The big question for me is whether Turnbull will bring the Opposition around to supporting legislation for an emissions trading scheme (after extracting various concessions of course). A couple of years ago, I would have been confident of his willingness and ability to do this. Now I doubt it.

* I have to declare a personal interest here. Nelson introduced the Federation Fellowship scheme under which I’m employed.

In the comments to my last post, reader Peter Schaeffer provides exactly what I asked for: a breakdown of the discrepancy between 30 per cent growth in US household income over the last 40 years and 117 per cent growth in income per person. In addition to the factors I’d mentioned (falling household size and growing inequality) Schaeffer notes two more: the fact that GDP has grown faster than national income and the fact that prices faced by households (the CPI-U-RS) have risen faster than the GDP deflator. He provides the details to show that this fully explains the discrepancy.

What should we make of this. As far as the situation of the average American is concerned, the only correction we need to make to the household income figures is to correct for changes in household size. That makes the increase over the last 40 years about 63 per cent, or an annual growth rate of 1.2 per cent. By contrast, the 117 per cent growth in GDP per person implies a rate of just under 2.0 per cent. So, changes in GDP per person (let alone changes in total GDP) are essentially irrelevant as a guide to how the average household is doing.

And of course, the poor have done much worse. Household incomes for the bottom quintile have barely moved for decades. Growth in consumption has been driven largely by increasing access to debt, a process that now looks to have run out of road. That would seem to indicate a looming social crisis. But the coming election will still turn on whether Obama called Palin a pig.

I was at a seminar the other week on inequality in US household income, and I asked the speaker about something that’s puzzled me for a while. I didn’t really get an answer, so rather than do a lot of work myself, I thought I’d try this crowdsourcing all the cool kids are talking about. Here’s the puzzle.

That’s when credit default swaps (CDSs) with a notional value somewhere between $500 billion and $1.4 trillion will have to be settled as a result of the (re)nationalization of Freddie Mac and Fannie Mae, which has been deemed to constitute a default event on their bonds. Paradoxically though because the government guarantee of the bonds is now explicit, they are actually safer than before which means that the net payments required in settlement will be very small, and sometimes go to the party who offered protection against default. Don’t worry too much if none of this makes sense, the main point doesn’t depend on it, but you can read a bit more from The Economist.

As The Economist notes, most participants are expecting all this to go smoothly. But one thing about the longrunning credit squeeze is that unexpected (bad) things tend to happen. So what could go wrong?Read more…

Assuming that he was pursuing a consistent plan at all, Peter Costello’s months of coyness about possible leadership aspirations now appear to have been designed to ensure a big splash for his memoirs. Presumably, his departure from Parliament won’t be long delayed and (while you should neversaynever) it seems that his political career is over.

Unlike with Howard, I’ve never really rated Costello. Undoubtedly he’s a sharp debater and has the good lawyer’s capacity to get on top of a brief, but in his twelve years or so as Treasurer, I didn’t see anything to suggest that he really understood economics or thought much about economic policy. His near-silence since losing office, despite repeated Labor attacks on his legacy seems to me to confirm this. Without the backup of Treasury and staffers, he doesn’t seem able to mount an effective argument (or maybe he just can’t be bothered). Perhaps his book will tell a different story though – I certainly expect it to sell pretty well given the promised bagging of so many colleagues.

The outcome of the Western Australian election remains undecided. Labor could hold on to power either by winning enough seats to govern with the support of independents or by making a deal with the Nationals. Conversely, the Libs need to win the seats in which they are currently ahead, and then cut a deal with the Nationals.

Apart from being a reminder of the folly of snap elections designed to capitalize on transitory political circumstances, this close result reminds me of something I’ve observed over time. Whichever of these two even-money chances is realised, we’ll come to think of it as inevitable. Consider for example Bush’s win in 2000, Howard’s in 1998 or Hawke’s in 1990. In each case, the vagaries of the electoral system turned a loss (admittedly narrow) on the votes into a winning outcome.

Yet with the possible exception of Bush, this fact is forgotten when we come to assess the electoral appeal of the winners and even more of the losers. Peacock, Beazley and Gore could all have reached the top if a few electoral dice had fallen differently. But they go down in history as failures while Bush’s two terms and Howard and Hawke’s four mark them as winners, at least until their luck ran out.

Measured by the dollar amount involved, the nationalisation of the mortgage guarantors Fannie Mae and Freddie Mac, announced today by the Bush Administration, is the largest in history. No less than $5 trillion of assets and obligations have been taken over by the US government in one hit.

Of course, that debt had long been regarded as having an implicit government guarantee and the companies involved were quangos (in the original sense of quasi-NGOs) rather than genuine private firms. Fannie was a government agency privatised in the 1960s, and Freddie was created to provide competiion for Fannie. So even though the US government will now guarantee virtually all new mortgages, this is more an admission of existing reality than a big step towards socialism.

While the quasi-governmental status of Fannie and Freddie was always problematic, this wasn’t the reason for their failure. Rather, they were pushed to accept increasingly bad loans made by the private sector. And when their difficulties became acute, the most satisfactory solution, under normal conditions, would have been to formalise the government guarantee of the existing loan book, then put them into run-off mode, writing no new business. But given the failure of the private sector, that would, mean, in effect, making it impossible for anyone to write a mortgage contract.

The fact that the credit crisis has reached this point marks the failure of the central claim of the neoliberal program, namely that private capital markets, free from intrusive government regulation, can enable individuals and households to handle the risks they face more flexibly and efficiently than a social-democratic welfare state.

In the boom that created this crisis, every part of the financial system (retail banks and mortgage businesses, major Wall Street banks, the financial engineers who designed new securitisation assets, investment funds, ratings agencies and bond insurers) had a major role to play. All have failed miserably, even though most will get to keep the rich rewards they received when things were going well.

Further update As various commentators point out, the failure here is one of actually existing neoliberalism. The “unknown ideal” of a perfect free market system remains pure and unsullied by empirical experience.

More seriously, the significance of the event is not in the marginal change in the status of Fannie and Freddie from quasi-private to quasi-public, but in the abandonment of the pretence that the normal operations of financial markets are capable of cleaning up the mess they have created, even with the liberal helpings of public money that have already been dished out.

I’m planning a full-length post on Garnaut, but I thought I’d do a quick check on what would be involved in meeting the target of a 10 per cent reduction in emissions between 2000 and 2020. My guess is that the increase in oil prices we’ve already seen will be enough to bring consumption of petrol and diesel back to the 2000 level, and that other sectors like agriculture will be roughly stable. That means that most of the reduction will have to be found in energy generation.

My rough estimate is that the use of brown coal in energy generation contributes around 10 per cent of total emissions (Update:After I revised my estimate to 15 per cent, reader Chris Short pointed me to a section of Greenhouse Gas Inventory I’d missed, which gives brown coal a 30 per cent share of electricity’s 34 per cent of emissions, so 10 per cent was right ), so, as a first approximation, the Garnaut target could be met shutting down the brown coal sector and replacing it with enough renewables to cover the brown coal share of existing electricity, and any growth in final consumption. Consumption growth would be constrained both by increasing prices and by conservation measures.

That would certainly require a substantial adjustment assistance program in the Latrobe valley and similar locations. We’ve done this kind of thing before, for example, with the end of the steel industry in Newcastle, sometimes well and sometimes poorly.

My guess is that the actual outcome would involve keeping some brown coal stations, with drying technology that reduces emissions to a level comparable with black coal, and some expansion of gas-fired power stations, offset by a combination of domestic offset measures and purchases of international offsets. The Garnaut cost estimates of around 1 per cent of GDP look pretty plausible for this. This story actually suggests a lower value, since $35 billion over 10 years is around 0.3 per cent of GDP.

One thing I’ve learned in life, though not always applied, is that if you ignore a job long enough, it often goes away. I was going to write a post excoriating Maurice Iemma and Michael Costa for their handling of the electricity privatisation issue, but it doesn’t matter much now (retail privatisation may still go ahead, but that’s not such a big deal either way). The earlier departure of deputy premier John Watkins is more of a loss, though no real surprise.

Labor now has a chance to salvage a government that looked to be utterly doomed. It’s a long shot, but the NSW Liberals have a long record of snatching defeat from the jaws of victory, so who knows.

A week ago my Fin column (over the fold) predicted a double dissolution over legislation to establish an emissions trading scheme. The rejection of the government’s changes to luxury car tax shortens the odds considerably. The government made a number of compromises to satisfy the Greens and Nick Xenophon that highly fuel-efficient vehicles would be excluded, but that only made it harder (in the end, impossible) to deal with Steve Fielding of Family First. The same problems will emerge, in spades, with an emissions trading scheme.

It seems likely that lots of legislation will be rejected between now and the time an ETS becomes a trigger,. If the government can hold its nerve, and its popularity, a double dissolution will look very attractive by then.